I’ve spent most of this week working on growth projections for financial plans, and wanted to share some of the results with you for your own planning needs. Those hit most by this will be the people working with financial planners (or brokers) who have been given a growth projection by some fancy software.
Unfortunately, using some of the best solution specific software available, I’ve encountered massive issues that your advisor may have missed. Firstly, sophisticated software tends to run from past performance of the stock/ETF/Fund that you are invested in, or, it runs on the past performance of the benchmark index that it is tracking.
I first noticed the issues when the returns seemed abnormally high for the current environment, where experts such as Bogle, et al are suggesting that a return greater than 5% for the foreseeable future (perhaps the next decade) are going to be hard to achieve. See here from about 2:42
When looking at the outputs from the planning software, I was getting a lot of 7-10% outputs. The reason is that the historical rates (looking back) are often huge by default. For example, TIPs were showing a historical rate of 6%, and short term bonds 3.4%. The numbers are clearly misleading because you can’t earn close to these rates in reality with the current market.
Who should worry?
If you’ve been given a financial plan by someone that shows growth rate, you should double check it. What is the growth rate they are using? What would happen to your plan if you dropped the rate down to 4% or 5% for the next 10 years? Will it survive, or are unrealistically high returns the only way for you to succeed?
Whether you have run your numbers with a professional, or with software, or as a simple compounding calculation, run them again one more time, plan lower.. and if your numbers don’t work, it might be the time to rethink the other things you can control, such as expenses, earning years, and making your investments more efficient.
+1 !
There is one MAJOR, MAJOR point / flaw most everyone overlooks when developing expectations about a ‘new normal’ 5% annual financial return. It is built on several ‘ifs’, of course:
* If the Fed achieves its 2% inflation target, and
* if the Fed achieves its ‘full employment’ target (which probably requires a larger percentage of workforce participation), and
* if as a consequence, the yield curve normalizes with short-term rates between 2% and 4% depending on where we are int he business cycle and longer term term rates similarly between 3% and 6%, THEN
* a 5% long-term return on financial assets is insufficient and should move towards the 7%+ that the historic models call for.
IF the whole term structure of interest rate expectations, interest rates and risk premia do move back towards historic norms, then almost all financial assets would drop precipitously in price. For example if the rate on 10-year treasuries rises from 2.25% to 5.25%, then the bond would fall roughly 20 percentage points in price. And equities, which have an implicit duration much greater than a 10-year treasure, might reasonably fall a lot further. If stock’s are akin to perpetual securities and the market’s required expected return change from 5% to 10%, then the prices of stocks would have to fall 50% to accommodate such a shift in market clearing returns.
The point is, unless you want to consider 5% both the new normal AND ALSO that the ‘new normal’ will persist far into the future, THEN the new normal is nothing more than a giant opportunity to lose a tremendous amount of principal. And why take the risk of so much loss of principal when the new normal’s opportunity cost is an expected annual 5% return?
Gold is never the answer.
Gold is never the answer. I agree completely.
Forgoing investment return and income might well be the answer. If you own a portfolio of long-term treasuries, and the 10-year rate exceeds 5% any time during the next 10 years, it’s quite likely you will have a negative total return at such point in time (significant negative real rate of return). That is a simple math problem.
It could well be that we would all be better off upgrading all our major appliances (getting more ‘utility’ from their upgraded qualities, getting a higher salvage value, and avoiding loss of principal had we saved the money), than owning them to the end of their operational lives. Lot’s of economic theory would suggest that such action is the implicit narrative of exceptionally low real-, and nominal- interest rates. It’s why such low real and nominal rates have the hope of generating economic growth.
US cars sales are at record levels for example. Home prices are rising at twice the rate of inflation. Homes are the ultimate durable good, and buying a home serves as a double whammy, because instead of investing in the tortured rate environment, a mortgage serves to borrow, that is to take advantage of this tortured rate environment. And if long-term interest rates rise, and you are locked into a low cost mortgage, that mortgage becomes akin to a financial asset even. (I.e., why would you sell your home financed with a 3.5% mortgage to buy a home and borrow at 6.5%?)
For those who have to manage financial assets for a living, the choice is to take today’s implicit returns, or ones with lower, perhaps much lower, current returns, but whose return profile improves as interest rates rise. For many, that kind of asset is cash-like securities (even in a 2% inflationary world, such is opportunity cost) which can be redeployed once rates ‘normalize’ (which arguably might not happen for a long, long time). For very specialized companies, those financial assets might look like IOs or mortgage servicing rights or the like. Suffice it to say, there are a few financial assets whose value rises as interest rates rise.
If you believe that there is a good chance the 10-year treasury will exceed 5% over then next 10 years, most investment models would suggest it will be very hard to get any nominal returns on financial assets. And of course, there is that inflation stuff too.
One way to personalize low nominal and negative real rates of return is to imagine the market saying, “We don’t need your stinkin’ money!” Because it clearly doesn’t. Just look at the returns it’s willing to give you. It’s like reselling to lose money.
All that may or may not be correct, but all that matters is your own wealth, assets, liabilities and cash flow.
That needs to be sorted first.
The point here is that if you cut off your income because you think you are getting 8% return you are doomed, because you are likely unemployable.
And while it is nice to say stay out of the market, doing so may guarantee you fail.
Your mantra of ‘first things first’ is very appropriate, and I know my conversation looks right past it. I don’t mean to suggest anyone neglect financial planning simply because the prospect of financial returns are so meager and perhaps significantly negative. And to close the loop before another round of lt:dr. If the prospect of financial returns are so bad, an optimal choice might be to save more AND invest less. Now for the lt;dr..
Staying out of the market only guarantees you fail if you are forgoing certain returns.
The rest is a string of unpredictable outcomes.
Rates are so very low. The risks of rates rising and falling are so a-symmetric. So why invest as if the risks of rates rising and falling are symmetric? If you think those risks are symmetric — that is, you might get unexpected windfalls as well as unexpected losses — then your statement,
“And while it is nice to say stay out of the market, doing so may guarantee you fail.”
is a reasonable description of expected outcomes in a symmetric environment. Of course, even if risks were symmetric, there is no guarantee that if you stay out of the market for an arbitrary period of time — a week, a year, or until the 10-year treasury yields 5% — that you will be worse off (or better off). It’s all about expectations.
When there is so much asymmetry to the potential paths of interest rates, traditional return expectation models break down. And a simple math exercise makes a very forceful point. If you invest in long-term treasuries, and the yield on the current 10-year treasury exceeds 5% within the next ten years, your investment will have declined in value and suffered significant real lose in value. It is probable, if bonds are beat up so badly, the stock market does badly too.
Consider two investment choices: a) invest in ‘cash’ until the 10-year treasury yields 5% and then invest as otherwise, or b) invest now (reinvesting income along the way).
For the sake of argument, investment choice ‘a’ concedes roughly 2% per year to choice ‘b’. And if the 10-year treasury never gets to 5%, in 10-years choice ‘a’ is 21.8% worse off. So in the Goldilocks scenarios where the bears never return from the woods, choice ‘b’ is the winner but 20% is only 20%. It is a non significant, but somewhat meager return earned over 10 years.
Otherwise, if at any time, the yield on the 10-year treasury rises to 5% and I invest at that point in time, I make more money. At 5% annual yield, I make 20% in not quite 4 years so waiting not only could improve my investment prospects dramatically and but it also preserves my principal.
If I change my mind in the future and decide that I should be invested rather than hold cash, but interest rates did increase somewhat, my opportunity cost could well be less than the initial 2% (and it’s subsequent compounding). So even then the cost is not so bad, and in fact, I may well have profited.
The only time the cost of choice ‘a’ increases is if 10-year rates fall from current levels. Here is where the rate asymmetry comes in. The Fed will go out of its way to stop such events from occurring, and their occurrence, Fed actions aside, are exceptionally rare.
I ignored stocks. My believe is that whenever there is a major revaluation in the bond market, stocks get it too. But if Vogel et al., are suggesting a 5% expected return which I happen to agree with, then if a revaluation occurs and expected returns reset to a level more in the 7% + range, it is odd-on that the choice to hold cash and then invest is the financially better one. A 5% perpetual drops almost 40% in price if it’s yield adjusts to 8%.
The basic question is: “Why take significant risk with wealth when the offered returns are so meager?” No one asks this question. Everyone says, “Over the long-term, your better off investing.” Such a statement has rarely been tested when there is such asymmetry in the potential direction of interest rates.
Bond math is very simple, and makes a very strong point: Low yields in and of themselves are a very high risk. From a mathematical point of view, the bond market right now is like Clint Eastwood pointing a gun at every investors head and saying, “Do you feel lucky punk?!”
With oil floating around in cargo ships, the dollar rising, China slowing down, and Europe struggling, do I feel lucky at the moment. Sure. Do I feel lucky for a long time. Sure. But that luck is already in the prices. And bond math asks the following question: “Do I feel 10 years lucky?” Because if I don’t, then I should walk away. Or Clint Eastwood will blow my head up.
Cash is not so bad when you hardly get paid for it to be anything else.